Some Floating Rates Won’t Float

Banks often raise money by issuing fixed-to-floating-rate preferred stock: They sell shares for $25, and for some fixed period (often five, seven or 10 years) those shares pay an annual dividend of, say, 6% ($1.50 per year, or $0.375 per quarter). And then after that they start paying a dividend that changes each quarter based on some benchmark interest rate. Usually the preferred stock is perpetual — the bank never has to pay it back — but it is callable: After it switches from a fixed to a floating rate, the bank can decide to pay it back at par ($25 per share). The rough idea is:

For many years, the standard benchmark interest rate was Libor, the London interbank offered rate, and fixed-to-floating preferreds normally reset to Libor plus some fixed spread. “Libor plus 4.0%,” the contract might say, and then if three-month Libor was 3.0% on some quarterly reset date, the dividend rate for that quarter would be 7.0% per year ($0.4375 for the quarter). (Technically this is a “dividend rate,” but it is natural and common to call it an “interest rate” instead, since the preferred is a fixed-income instrument.)